Historically, investors looked to equities and fixed income to generate income and capital gains. These two traditional asset classes remain front and center of the financial landscape. Increasingly, however, institutional investors and wealthy individuals are moving into so-called alternative investments to diversify their portfolios and generate higher returns.
The growth in alternative investments is staggering. According to data from PWC, assets in these strategies are expected to hit over US$21 trillion in 2025, a massive increase from the US$2.5 trillion level recorded in 2004.
It’s important to point out the gulf that exists between current institutional allocation to alternatives versus that of individual investors: According to a presentation by Blackstone, pensions and endowments have between 27-29% of their portfolios in alternatives. This compares to less than 5% for individuals. As to how much an individual should consider allocating to this asset class, opinions vary. Morningstar Research argues that 3-10% might be appropriate for retail investors, whereas other experts believe you need 10-20% to meaningfully “move the needle” in a portfolio.
There isn’t one definition of what constitutes an alternative investment. That said, the Harvard Business School suggests that all alternatives share the following three characteristics:
- They’re not regulated by the SEC
- They’re illiquid
- They have a low correlation to standard asset classes
With this expansive definition, the universe of alternative investments is fairly broad. Indeed, the Harvard article identifies Collectibles as one such strategy. That said, the bulk of investor money is directed to the 4 main alternative investment approaches: Hedge funds, Private Equity, Real Estate, and Venture Capital.
With this in mind, let’s take a look at each of these strategies:
Hedge Funds have typically only been available to wealthy and sophisticated investors. Beyond this air of exclusivity, these vehicles are attractive because of their flexibility. Whereas most mutual funds are more or less long-only, for example, hedge funds usually can typically establish short positions, either against a particular stock or the overall market. Moreover, they can usually use derivatives, both for hedging and speculation, either to reduce risk or seek higher returns.
It’s important to note that the term Hedge Fund is quite broad, and captures many different strategies within it. Within the hedge fund category, these are some of the more common variants:
- Long-short equity
- Global macro
- Merger arbitrage
- Fixed income arbitrage
Private Equity investments are those made outside of public, listed stock markets. PE firms usually have stakes in multiple companies at one time, although their holdings tend to be more concentrated than a fund managing a portfolio of public equities. While they can choose to take passive stakes in ventures, many prefer a more hands-on approach to maximize returns. This can involve anything from helping mentor the company’s executives to sharing industry expertise and connections.
PE firms receive their funding from investors, who are known as Limited Partners. Once a suitable opportunity arises, the firm takes a substantial stake in a business (50%-100% is not uncommon). This investment can be funded with a combination of equity and debt, with the latter guaranteed by the assets of the company being acquired in what’s known as a leveraged buyout (LBO).
Venture Capital firms are similar to PE outfits in the sense that they both invest in private markets. There are key differences, though. For one thing, Private Equity is focused on larger, mature businesses from a whole host of industries. Venture Capital firms, by contrast, deploy their capital into early-stage investments. These commitments tend to be concentrated across just a handful of industries, such as information technology and clean tech.
Real Estate is the final major alternative investment. Funds in this category may look to residential or commercial property for both income generation and capital growth. Undoubtedly, the current era of low interest rates has been a key driver of real estate’s appeal to investors. Traditional fixed income investments, such as government or corporate bonds, pay little in either real or nominal terms. Additionally, low rates mean that borrowing money to fund real estate investments has never been cheaper.
Other Alternative Assets
In addition to the main groups listed above, there are other alternative investments that often receive investor attention, such as:
- Managed futures strategies
- Real assets such as timberland
The Investment Case for Alternative Assets
Alternative investments are attractive for a few key reasons, as detailed by a report from the Chartered Alternative Investment Analyst Association:
- The potential for enhanced returns. Whether in the private markets (PE, VC, and real estate) or via hedge funds, alternative investments can deliver greater returns than either public equities or fixed income.
- Diversification. In addition to enhancing returns, alternative investments often have either a low or negative correlation with broader indices. This offers both the possibility of a hedge against market turbulence as well as the potential to lower the volatility of an investor’s portfolio.
- Inflation hedging. Alternative investments, such as real estate, are considered real assets (as opposed to financial assets). And while inflation is currently quite low, these holdings may be a refuge in the event that it returns with a vengeance.
What are the Risks?
Naturally, the chance for higher returns does come with increased risks. In the case of alternative investments, illiquidity is the clearest downside. Whereas an investor can sell a position in a large cap publicly-traded stock almost instantaneously, the same cannot be said of most alternatives. Indeed, for many alternative investments, there are lockup periods designed to give the portfolio managers breathing room and a greater sense of how much liquidity they will have on hand.
Valuation is another key risk for investors in alternative investments. Due to the heightened liquidity in most equity and fixed income markets, identifying a market price is fairly straightforward. The same isn’t true with alternative investments that are subject to estimates and judgements to arrive at a current valuation. As such, there is a risk that managers may report valuations in excess of what an asset is truly worth.
Common Fee Structures
There’s a well-known phrase associated with hedge fund and private equity fees: 2 and 20. In other words, a 2% management fee based on how much an investor has in a fund, plus a 20% performance fee. It’s a model that is designed to reward managers that deliver solid returns.
Increasingly, fee structures in alternatives are evolving. Take hedge funds: What used to be a 2% management fee now averages somewhere around 1.3%. On the flip side, fund managers can receive even more (20-30%) as a performance fee.
What to Look for in a Good Manager
There are many thousands of alternative investment managers. So how do you find a good one?
A track record of solid returns is a smart place to begin. Past performance, of course, doesn’t guarantee anything in the future, but you may be able to glean important insights from it. For example, does a manager have a history of large gains followed by equally significant drawdowns? Or have they demonstrated an ability to deliver meaningful returns year in and year out through different market conditions?
In looking for an alternative investment manager, you may also be able to assess the team they’ve assembled, as well as the strategy they’ve articulated. With regards to the latter, do they seem to have people in place with sufficient expertise in their particular sector? As for their strategy, do any written materials or public interviews reveal a deep subject matter understanding and a concise thesis about a given market?
If venturing into an asset class is the horse, then the manager is the jockey you’re betting on. Choosing both correctly is at the heart of excess investment returns. The good news is, PitchBoard can help. We help investors meet the fund managers who may be able to produce compelling returns now and well into the future. Learn more here.